Portfolio heat basically answers the question of how many new positions you can have open at any one time.
Professional traders use this technique to manage and quantify their total risk in the market.
They understand that trading is about the successful management of risk and they always know what the worst-case loss would be if all their positions were to hit their stops today.
For example, if you always position size your trades based on risking 1% of your total capital, how many of these trades would you be prepared to have open at any one time? In dollar terms, how much money would you be willing to lose if all your stops were hit in one day? By answering these questions, you will be able to determine a suitable portfolio heat level.
Let's say that you risk 1% of your capital on each new trade and you are willing to withstand a 5% portfolio heat level.
This means that you have no more than five initial positions open at any one time.
So your worst-case risk if all your stops were hit tomorrow would be 5% of your total equity (excluding brokerage costs).
When you have opened up five initial positions in the market at a total of 5% risk, you cannot open up any further positions until one of the trades moves in your favour and you are able to move your initial stop loss to break even.
Once you have moved an initial stop to breakeven, this means that your portfolio heat now drops back to 4% and you can open up a new position at 1% risk (if one becomes available and you still have trading capital available).
If you are using 2% risk, then you may decide to set your portfolio heat to 6%.
This means you can have three initial positions open at 2% risk each.
When starting out as a trader, it is best to keep your portfolio heat set at a low level.
Once you have two or three positions open, wait until you have moved one of the initial stop losses on a trade to break even before opening another.
This will help you manage your risk in the market while you are still learning.